AM Best
Run-off: no longer an option of last resort
Alex Rafferty of AM Best explains how motivated sellers and active buyers are fuelling a buoyant market for non-life run-off reserves.
“Whether the aim is economic, operational or legal finality, the insurer transfers risk to a counterparty with the transaction.”
Alex Rafferty, AM Best
Activity in the global non-life legacy (run-off) insurance market is buoyant. Over recent years, the sector has seen a steady increase in the number of transactions executed. Run-off is no longer seen as an option of last resort and indicative of failed operations. Increasingly, re/insurers are using the legacy insurance segment as part of their capital and risk management strategies, often for long-tailed insurance liabilities.
A multitude of demand and supply side drivers are fuelling the momentum. The current hardening conditions in the live market, demand for greater capital and operational efficiencies and an influx of capital deployed into run-off consolidators, are all significant factors.
However, competition in the segment is high, and pricing pressures have the potential to weigh on prospective margins. Additionally, uncertainties around reserve adequacy and the impact of social and wider inflationary trends on long-tail liability valuations present headwinds to those operating in the segment.
Global run-off reserves continue to rise
According to PwC’s latest non-life “Global Insurance Run-off Survey”, global run-off liabilities amounted to $860 billion in 2021, and have been increasing over recent years (2018: $730 billion). The growth in run-off reserves from discontinued business held on the balance sheets of insurers is a strong contributory factor to the currently active legacy market.
The survey also identifies the US as the largest single market for run-off reserves, representing 45 percent of the global estimate. States such as California, Florida and New York are among the largest contributors to the total. AM Best notes that the US has long been an active market for legacy insurance transactions, given its size and the unique stock of long-tail reserves built up over time due in significant measure to the role of the US legal system.
The UK and Ireland also have a long history in the run-off segment. Similar to the US, reserves for asbestos and other industrial exposures have been the subject to legacy transactions for many years. Furthermore, the Reinsurance to Close (RITC) structure within the Lloyd’s market has provided a regular mechanism for syndicates to close older years of account into more recent open years and with third-parties.
“RITC transactions in the Lloyd’s market with non-aligned counterparties may be required to be accounted as reinsurance contracts.”
Given the long-duration tail associated with casualty classes, insurance liabilities associated with workers’ compensation, professional liability, asbestos and environmental and other liability lines, have comprised the lion’s share of run-off reserves on companies’ balance sheets and are the reserves typically subject to run-off transactions.
Rising inflation, driven by economic or social factors, is adding increasing complexity to the accurate estimation of casualty liabilities, increasing the risk of adverse reserve development for insurers carrying these reserves. This can motivate an insurer and its stakeholders to execute transactions that insulate them from legacy deterioration.
On the other hand, property and damage-related classes of business are generally more short-tail in nature, with the final liability and exposure of the insurer determined relatively quickly after the date of loss. These reserves typically do not lead to protracted run-off periods and have historically been less prevalent in run-off transactions.
Legacy market dynamics: motivated sellers
The drivers for insurers engaging with the run-off market are numerous. AM Best has observed that capital management, addressing underperforming business segments, operational efficiency, reducing uncertainty and risk management considerations all play a role. In the context of the prolonged low interest rate environment of recent years, there is increased need for insurers to leverage all aspects of their operations to generate returns sufficient to meet their cost of capital.
Entering into a transaction to dispose of legacy liabilities is designed to provide the incumbent insurer with finality for the business or portfolio in question. Whether the aim is economic, operational or legal finality, the insurer transfers risk to a counterparty with the transaction.
The wider implementation of risk-based regulatory solvency regimes has contributed to greater visibility of capital utilisation, allocation and efficiency. Accordingly, the extent to which legacy reserves for discontinued business weigh on insurers’ solvency capital requirements and risk-adjusted returns can be more easily identified, and the potential benefits of entering into a third-party run-off transaction can be better quantified.
Capital released following a legacy transaction can be quickly reallocated to business segments more accretive to earnings, and supportive of the organisation’s current business strategy. Good pricing conditions in many primary insurance markets underline this benefit, with capital released from legacy business able to be deployed into well-priced business in core segments.
The motivation to improve operational efficiency is also a significant driver of demand for legacy transactions. The management of legacy liabilities can be both time consuming and costly for an insurer.
Maintaining legacy IT systems and infrastructure is often burdensome, which along with dedicated claims and actuarial resources, can contribute to operational inefficiencies and an earnings drag for an insurer.
Additionally, legacy portfolios are often not managed actively, resulting in longer claims settlement times, greater potential for reinsurance disputes and the build-up of additional expenses over the run-off period. Through entering into a run-off transaction, an insurer can often transfer operational responsibility and claims management to the counterparty, providing operational finality.
Entering into a legacy transaction also mitigates uncertainty arising from volatile reserving books, or underperforming business segments, providing insurers the ability to ‘clean up’ balance sheets and protect prospective earnings from the adverse deterioration of legacy reserves. In keeping with this, recent efforts in the Lloyd’s market to remediate and strengthen underwriting performance have been a catalyst for Lloyd’s syndicates seeking out solutions for their legacy and underperforming liabilities.
Legacy market dynamics: active buyers and new market entrants
The legacy market includes traditional reinsurers, such as Berkshire Hathaway’s National Indemnity Company, and specialist run-off consolidators—companies focused on the acquisition of run-off operations and providing exit solutions to the insurance market. A recent influx of capital into the niche run-off consolidator segment, along with new market entrants, such as the 2020 launch of Marco Capital, is fuelling activity in the legacy market.
Capital inflows are reflective of market opportunities, given the potential scale of the market and stock of global legacy reserves. Market estimates suggest in excess of $5 billion has been contributed to the segment in recent years. While capital providers are diverse in nature, the segment has increasingly seen an influx of private equity and institutional backers attracted by the potential for returns uncorrelated to financial markets and other insurance-linked securities (such as catastrophe bonds).
Legacy market participants, both established and recent startups, have increasingly sought access to the Lloyd’s market. Performance improvement initiatives within the Lloyd’s market have supported deal flow and the establishment of dedicated RITC syndicates.
As of April 2022, there are six specialist RITC syndicates operating at Lloyd’s. This represents a doubling of the number of RITC-focused syndicates since 2019, with the entrance of Premia, Compre and most recently Marco Capital.
The run-off segment is a competitive market place. Successful operators must exhibit pricing discipline, robust due diligence processes and transaction execution capabilities. Furthermore, the ability to meet the counterparty credit requirements of the transaction partner, for example through the use of a sufficiently rated balance sheet or high-quality collateralised solution, is central in demonstrating sufficient financial strength to protect policyholders over the run-off period.
Run-off consolidators use several levers to generate value from their acquisitions. The favourable run-off of the reserves acquired is a core profit driver, as are the returns generated on invested assets backing those liabilities. In many cases, operational and claims control is included for portfolios subject to reinsurance solutions, which allows the acquirer to manage the reserves and reinsurance recoveries in a proactive and strategic manner, thereby reducing settlement amounts and costs.
The ability to determine the ultimate claims cost accurately is crucial in identifying value opportunities and to protect against the risk of adverse deterioration post-acquisition. Given the long-tail nature of liabilities often subject to legacy transactions, appropriate reserving assumptions are a critical consideration. Current emerging inflationary trends, coupled with social inflation effects, present clear headwinds to the sector’s ability to preserve reserve adequacy over the run-off period.
With the recent increase in the capacity deployed, the run-off sector is set to remain highly competitive over the coming years. Ultimately, this enhanced competition may pressure prospective returns and companies’ ability to meet their cost of capital.
Legacy insurance deals landscape
Legacy transaction volumes picked up into 2021 following COVID-19-related disruption (Figure 1). This momentum has carried over into early 2022, with several large transactions announced to date for estimated total liabilities of $4.2 billion.
Figure 1: Run-off–estimated gross liabilities and number of deals
In any one year, the legacy market often includes a small number of particularly large transactions, making year-on-year volume comparisons appear somewhat volatile. Furthermore, transactions are often complex and weighted towards the end of the year, meaning that delays in completion can materially impact the volumes transacted in that year.
AM Best believes that, with the combination of motivated sellers and active buyers with capital to deploy, deal flow in the legacy market is expected to remain buoyant in 2022 and beyond.
Regulatory focus
Regulators play a significant role in the legacy market, with transactions and acquisitions subject to regulatory approvals ahead of completion. For run-off consolidators, demonstrating their ability to meet evolving regulatory demands is a dynamic that must be managed actively.
Regulatory focus ultimately aims to ensure policyholder protection—from financial strength and conduct perspectives—throughout the run-off period, a risk that can be elevated when there are changes in counterparties and contract administrators. For regulators in the UK and the EU, recent focus has fallen on the operational capabilities of run-off players to handle transacted liabilities and the ultimate exit strategies of the segment’s backers.
Regulatory developments are also fuelling the segment. In certain jurisdictions, such as in the UK through its Part VII Transfer mechanism, legal insurance business transfers have long been possible. In others, it remains an emerging tool.
Insurance regulators in the US State of Oklahoma approved the US’s first third-party Insurance Business Transfer in 2021. While several US states, such as Rhode Island and Vermont, also have insurance business transfer legislation, the successful completion in Oklahoma sets the stage for wider legal finality solutions in US markets.
IFRS 17
Run-off segment operators that report under International Financial Reporting Standards (IFRS) face several important considerations with the upcoming implementation of IFRS 17 in 2023. Compared with the existing IFRS 4 standard, IFRS 17 will reduce variations in treatment across geographies.
One area in which IFRS 17 will have an impact is the emergence of profit. Under the current standard, profit may be recognised on transaction completion, but under IFRS 17, profit will be recognised as services are rendered over the coverage period, with this coverage period being the settlement period of the run-off liabilities. IFRS 17 is required to be applied retroactively, which may result in significant restatement of opening balance sheets on adoption.
Additionally, the discounting of liabilities presents a material change from current practice, and may provide a more economic view of casualty books.
AM Best expects most run-off consolidators adopting IFRS 17 to apply the General Measurement Model (GMM) of IFRS 17, as opposed the simplified Premium Allocation Approach (PAA). This reflects the generally long-tail nature of the coverage period for legacy transactions under IFRS 17, and is viewed as carrying increased complexity.
It is not only acquirers of legacy portfolios that are set to be impacted by the introduction of IFRS 17. In a small number of instances, what was originally considered to be a finality solution may no longer be the case.
In particular, RITC transactions in the Lloyd’s market with non-aligned counterparties may be required to be accounted as reinsurance contracts, rather than finality solutions. This would have the effect of requiring the disposing party to continue recognising the gross liabilities on its balance sheet, along with a reinsurance asset relating to the RITC counterparty, after the RITC transaction rather than reflecting a disposal.
A requirement to re-recognise previous reserves subject to RITC transactions would bring a significant operational burden given that the claims and policy data are normally held by the broker and RITC counterparty rather than the reinsuring syndicate.
Finality solutions: what’s available to insurers?
Typical transaction structures include reinsurance contracts, such as loss portfolio transfers (LPT) or adverse development covers (ADC), legal insurance business transfers and entity acquisitions. Often a transaction will include a number of these structures, with reinsurance providing immediate relief while regulatory permission is sought for an ultimate conclusion.
Notwithstanding the transaction form, the run-off specialist will receive assets as consideration for assuming the liability for the payment of losses associated with the subject reserves.
Reinsurance contracts
Insurers can often achieve sufficient economic and operational finality for their legacy reserves through reinsurance transactions, with the financial risk of adverse reserve development and administrative responsibility being transferred to the run-off market. Insurers entering into such transactions will be required to manage the counterparty credit risk arising from it.
Additionally, reputational risks are also present, particularly if operational control of interactions with policyholders is included in the transaction.
Insurance business transfers
Often following an initial reinsurance contract, legal finality can be achieved through insurance business transfers, such as through the Part VII Transfer mechanism in the UK, with the subject reserves legally transferred to the balance sheet of the counterparty.
Disposals
The sale of a legal entity and its remaining liabilities, both insurance and non-insurance, can provide a clean exit for the seller. For the acquirer, it offers the opportunity to acquire a licensed balance sheet in a strategic jurisdiction that is potentially useful for future transactions. A steady stream of corporations disposing of legacy captive insurers is a tailwind for this segment.
This article is an excerpt from a June 2022 AM Best special report “Motivated Sellers and Active Buyers Fuel Buoyant Market for Non-Life Run-Off Reserves”.
Alex Rafferty is associate director, AM Best. He can be contacted at: alex.rafferty@ambest.com
